Recession Risks and Investment Implications

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I refuse to believe, despite gathering evidence to the contrary, that I am getting older.?This being my mindset, I am perpetually astonished by the increasing youth of my colleagues.?According to the Census Bureau, the median age of an American today is 38 years which doesn’t, on its face, sound extraordinary.?However, what it does mean is that most of the people I work with have only experienced two recessions in their adult lives – the recession of 2007-2009 and the recession of 2020.??

I suppose if that were my only real experience of recession and I heard that another recession was imminent I would be more than a little worried.?However, when thinking about recessions and investing, a more balanced and longer-term view is required.?

The Federal Reserve’s aggressive 0.75% rate hike last Wednesday led to a further sharp slide in U.S. equity markets as fears of recession were added to the reality of high inflation.?The S&P500 fell by 3.3% on Thursday and, despite a small rebound on Friday, is now deep in bear market territory, down 23.4% from its January 3rd high.

Investor concerns are understandable, given the array of forces now undermining economic momentum.?However, there is still great uncertainty as to whether these forces will be enough, in today’s very unusual environment, to trigger an actual recession.?More importantly, even if the economy does end up in recession, investors need to consider how severe and long-lasting that recession might be, the kind of investment environment that could emerge in its wake and what this all means for positioning assets today.

The Risk of Recession

In trying to assess the risk of an economic downturn, it’s worth reviewing the actual definition of recession.

Economists often use a back-of-the-envelope definition of two consecutive quarterly declines in real GDP.?However, the scorekeeper of U.S. recessions, the Business Cycle Dating Committee of the National Bureau of Economic Research uses a broader definition.?A recession, according to the committee, involves a significant decline in economic activity that is spread across the economy and lasts more than a few months.?Recessions start at a peak in economic activity and end at a trough.?In determining the peak and trough months, they look at a wide variety of indicators including (1) real personal income excluding transfers, (2) nonfarm payroll employment, (3) employment as measured by the household survey, (4) real personal consumption expenditures, (5) real wholesale and retail sales and (6) industrial production.?In determining peak and trough quarters they also look at real GDP.

Some commentators have opined that the U.S. is already in recession.?However, it is hard to make this case based on the definition above.?In particular,?

? In April, real personal income excluding transfers rose 0.3%.?Given the sharp 1% increase in CPI in May, this income measure may well have fallen last month but should recover in June.?Indeed, with wages rising fast and the potential for inflation pressures to ease just a bit, real personal income excluding transfers should continue to rise for as long as employment is growing.

? Nonfarm payroll jobs and household survey employment lodged healthy gains of 390,000 and 321,000 respectively in May.?There are, however, some signs of diminished momentum in the job market.??

Most notably, initial unemployment claims have been drifting up, with the four-week moving average climbing from 170,000 per week in early April to 223,000 by mid-June. That being said, 223,000 is still a very low number by historical standards and continuing unemployment claims have maintained a steady downward drift in recent weeks to near record low levels.??

In its May survey, The National Federation of Independent Business reported that 51% of small businesses had positions they could not fill, tying a 48-year record high set last September.?Moreover, the next few months should see some further increase in labor supply as tight budgets force some back into the labor market.?While job openings may decline from very elevated levels in coming months, employment growth should remain broadly positive, even if the economy shows signs of weakness elsewhere.

? Consumer spending could be the economy’s greatest potential area of vulnerability.?Real consumer spending rose solidly in both March and April but likely fell in May as suggested by a 0.3% decline in retail sales and a 1.0% climb in overall consumer prices.

There are some sources of support for spending.?Both solid wage gains and rising employment should boost labor income and there should still be plenty of pent-up demand for autos and other consumer products that fell into short supply over the pandemic.?Consumer spending on travel, leisure and entertainment should also be helped by a further fading of pandemic concerns.

However, high-frequency data on flights, hotels and restaurants suggests some fading of this recovery in recent weeks.?More importantly, an absence of further government aid has cut the personal savings rate to 4.4%, its lowest level since 2008, as consumers have added to credit card debt to pay for more expensive gasoline and groceries.?This reality, combined with record low consumer sentiment and a sharp drop in financial markets, should lead to weakness in spending in the months ahead which could show up in declines in real consumer spending as well as real wholesale and retail sales.

? Finally, industrial production rose a modest 0.2% in May.?Low inventories should prompt greater production in the months ahead.?However, with the real trade-weighted dollar at close to its highest level since the mid-1980s and the global economy slowed by Ukraine and Covid in China, U.S. manufacturing is facing its own headwinds.?The ISM and Markit manufacturing indices for May, at 56.1 and 57.0 respectively, remain solidly in expansionary territory.?Last week’s June releases from the Philly Fed and Empire State surveys showed some softening in activity and this week’s June flash Markit indices will be watched closely for further signs of weakness.?However, overall, as is the case with employment, a lot of momentum will need to fade before production measures actually flash a recession warning.

Summing up the monthly data, there is a problem with final demand that will likely grab headlines in the months ahead.?However, the post-pandemic catchup necessary in employment and production should be able to keep the overall economy out of a broad recession, at least over the next few months.

A similar argument can be made on a quarterly basis.?Although real GDP declined in the first quarter, incoming data continue to point to a solid increase in the second suggesting that a recession did not start in the first half of this year.

All of this being said, recession pressures are building as the economy faces massive drags from an end to government pandemic aid, a sharply higher dollar, sharply higher mortgage rates, a negative wealth effect and slumping consumer confidence.?Moreover, the sudden surge in recession talk could, in itself, induce business caution, pushing the economy closer to a downturn.??

Investment Implications

For investors, however, it is important not just to worry about recession but to think through the implications of a recession, should one occur.

First, if the U.S. does fall into recession, there is no reason to believe it would be deeper than average.?This is particularly important to recognize since the last two downturns, the Pandemic Recession and the Great Financial Crisis Recession were the two deepest recessions since World War II.??

While the pandemic recession was, of course, a unique event in modern history, most other recessions involve some cyclical sector of the economy, such as home-building, autos, capital spending or inventories, going from boom to bust.?It is noteworthy that none of these sectors is overextended at the current time and so is unlikely to experience a major collapse.?In addition, the financial sector is far better capitalized than before the Great Financial Crisis, so it is unlikely that a recession would be amplified by widespread banking failures.

Second, while a recession might not be deep, the weakness in the economy could linger for a while.?Notably, the November mid-term elections are likely to result in a Republican takeover of the House, the Senate or both.?If this occurs, it is unlikely that Washington would produce any major fiscal stimulus until after the 2024 presidential election. The Federal Reserve would likely reverse its current tightening path if the economy actually fell into recession.?However, the speed and degree of monetary stimulus might well be limited by a Fed fear of prolonging inflation.?More importantly, the last long and very slow economic expansion showed just how ineffective easy monetary policy is in promoting strong economic growth in the absence of accompanying fiscal stimulus.

All of this is important for investors as it suggests a sluggish economic recovery which would erode inflation pressures and wage growth.?Moreover, in the absence of fiscal stimulus, the Federal Reserve could become easier over time leaving us back in an environment much like that of the last expansion, namely one of slow growth, anemic wage gains, low inflation, low interest rates and high profitability.?In this post-recession environment, both U.S. stocks and bonds could do well and a lower dollar could help foreign assets.

A third critical issue is whether and how to time investing around recessions.

Since 1947, the U.S. economy has endured 12 economic recessions and seen 12 equity bear markets (that is to say a price decline of 20% or more in the S&P500).?There have, however been four recessions that didn’t involve a bear market and four bear markets that didn’t involve a recession so the correlation is by no means perfect. Also notable is that the stock market leads the economy.?In seven of the eight recessionary bear markets, the stock market peaked before the economy (by an average of six months) and in seven of eight, the stock market troughed before the economy (by an average of two months).??

All of this points to the peril in trying to time investments around recessions.?We don’t know, particularly because of today’s very unusual configuration of economic forces, whether we will have a recession or not or when, if we do, one might start.?We don’t know where the trough might be in today’s equity bear market or how soon forward-looking investors might start betting on a recovery, should a recession occur.

We do know, however, that we still live in an economy of long summers and short winters.?Since 1946, the average recession has lasted for 10 months – the average expansion has lasted for over five years.??

We also know that just as the economy expands most of the time, the stock market on average goes up.?Despite 12 bear markets and many corrections since 1946, the S&P500 has risen at a compound annual rate of 7.2%, before dividends.

Finally, we know that, in the long run, valuations matter.?While this year has been very painful for all investors, the S&P500 is now trading well below its 25-year average forward P/E ratio and both U.S. value stocks and international stocks are trading well below their average multiples relative to the S&P500.?It seems we are doomed to a summer of discontent and this could be topped off with a U.S. recession.?However, for long-term investors, it is ultimately more important to be well-positioned for expansions than to try to tactically trade around?recessions.?

For more of my insights, listen to my?Insights Now podcast ?for a breakdown on big ideas, future trends and their investment implications.

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